April 16, 2020
Clients, Friends, Associates:
The first quarter of 2020 saw an unprecedented combination of challenges, not only industry-wide but on a global scale as well. Notwithstanding the prevailing circumstances, the first quarter was busy for investment managers and service providers with filing deadlines, regulatory changes, and compliance updates. As we continue through 2020, we have put together this update and checklist to help managers stay on top of the business and regulatory landscape in consideration of the global pandemic affecting nearly every aspect of the industry and our lives.
Please note COVID-19 related matters appear at the end of this update.
SEC Releases 2020 Examination Priorities. The SEC Office of Compliance Inspections and Examinations (“OCIE”), which conducts examinations of SEC-registered investment advisers, investment companies, broker-dealers, and others, publishes an annual list of examination priorities for the upcoming year that provides insight to managers regarding issues that will be examined and an opportunity for advisers to prepare and improve such areas before examination.OCIE’s 2020 exam priorities are as follows: Retail Investors (including seniors and those saving for retirement); Market Infrastructure; Information Security; Focus Areas Relating to Investments Advisers, Investment Companies, Broker-Dealers, and Municipal Advisors; Anti-Money Laundering Programs; Financial Technology and Innovation (including Digital Assets and Electronic Investment Advice); and oversight of the Financial Industry Regulatory Authority (FINRA) and Municipal Securities Rulemaking Board (MSRB). In particular, Information Security and Cybersecurity were focuses of the publication. OCIE released observations that focus on certain approaches taken by market participants in regards to governance and risk management, access rights and controls, data loss prevention, mobile security, incident response and resiliency, vendor management, and training and awareness.
SEC Division of Trading and Markets Releases FAQ on Regulation Best Interest (Reg BI). Reg BI establishes a “best interest” standard for broker-dealers and associated persons when making recommendations to retail customers involving securities. Since adopting Reg BI on June 5, 2019, the SEC has released responses to frequently asked questions about the regulation, covering topics surrounding Retail Customers, Recommendations, Disclosure Obligations, Care Obligations, Conflict of Interest Obligations, and Compliance Obligations. It should be noted that like all staff guidance, the FAQ does not have legal force or effect, but represents the views of the staff of the Division of Trading and Markets. Reg BI was met with much skepticism as critics found the new regulation ambiguous in many regards. Hopefully the SEC’s guidance will be the first step in addressing this perceived ambiguity. Firms are expected to comply with Reg BI by June 30, 2020.
Amendments to the FINRA New Issue Rule (Rule 5130) and Anti-Spinning Rule (Rule 5131) Became Effective as of January 1, 2020. Generally, the amendments to the FINRA New Issue Rules broaden the types of investors that are exempt from the rules’ restrictions and narrow the types of the securities offerings that are subject to the New Issue Rules. As a result of the amendment, among other things, FINRA member broker-dealers may now sell new issues to additional kinds of investors directly or through investments in private investment funds. Amendment to Rules 5130 and 5131 includes expanding the ways that foreign investment companies can fall within the general exemption, broadening the definition of family investment vehicles, including foreign employee retirement benefits plans under the exemption, excluding sovereign entities from the definition of “Restricted Persons,” and other changes.
FINRA Releases 2020 Risk Monitoring and Examination Priorities Letter. The 2020 Risk Monitoring and Examination Priorities Letter outlines the priorities for FINRA’s risk monitoring, surveillance, and examination programs for the year. The letter includes a list of practical considerations and questions for firms to use as guidance in evaluating their compliance, supervisory, and risk management program. Among the new or emerging areas in the industry, FINRA discusses compliance with obligations relating to Regulation BI, Form CRS, communications with the public, communications via digital channels, sales of initial public offering (IPO) shares, digital assets, cybersecurity, and other items.
Digital Asset Matters
SEC Commissioner Proposes 3-Year Safe Harbor Period for Crypto Token Sales. As mentioned in Commissioner Peirce’s speech, cryptocurrency and digital asset entrepreneurs are faced with a regulatory Catch 22. In order to build a decentralized network in which a token provides access to a function of the network or serves as a means of exchange, a crypto project needs to get its tokens into the hands of users. However, such would-be networks generally cannot freely distribute their tokens to potential users due to existing federal and/or state securities laws. Consequently, these would-be networks cannot mature into functional decentralized networks that are not dependent upon single persons or groups to carry out the essential managerial or entrepreneurial efforts (under the Howey Test). To address this uncertainty, Commissioner Peirce formally proposed a safe harbor for token projects, allowing a three-year time window for networks to mature and become sufficiently decentralized so as not to fall under the “securities” definition contemplated under the Howey Test. If adopted, the safe harbor would impose strict requirements on such crypto projects, including source code disclosures, transaction history disclosures, personal disclosures, public notices and filings, and other conditions. Additionally, the safe harbor would be available for tokens that were previously sold in a registered offering or pursuant to a valid exemption under the Securities Act of 1933, as amended.
SEC Wins Injunction against Telegram in Landmark Digital Assets Case. On March 24, U.S. District Judge Kevin Castel of the Southern District Court of New York issued an injunction against Telegram Group Inc. (“Telegram”), the messaging app company that raised $1.7 billion in 2018 selling Gram tokens to investors in the largest ICO to date. In October 2019, the SEC sought to enjoin Telegram from distributing the Gram tokens on the grounds that the company had violated federal law for the sale of unregistered securities. The SEC was granted the preliminary injunction, preventing Telegram from distributing the Gram tokens to investors. The Court stated it “finds that the delivery of Grams to the Initial Purchasers, who would resell them into the public market, represents a near certain risk of a future harm, namely the completion of a public distribution of a security without a registration statement.” Despite the ruling, it has been reported that the Telegram Open Network (TON) Community Foundation remains optimistic as they believe that TON can always be launched by anyone considering the network code is available.
Crypto Crash Leads to BitMEX Outage, Liquidations. As the price of Bitcoin crashed from $8,000 to nearly $3,700 in less than 24 hours on March 13, BitMEX faced a 25 minute outage during a day when nearly $1 billion in leveraged long positions were liquidated industry-wide. BitMEX has faced criticism for the outage, with some speculating that it may have shut down intentionally to avoid the possibility of its Bitcoin perpetual swap collapsing to zero due to forced liquidations. BitMEX has stated that a hardware issue caused the outage. No matter the cause, this event highlights the necessity for digital asset managers, especially those using leverage to trade digital assets, to ensure their fund documents contain the necessary disclosures regarding counterparty risk and digital asset exchange risks.
Wyoming Plans to Create New Bank Dedicated for Digital Assets. Wall Street and crypto veteran Caitlin Long recently announced a plan for Wyoming corporation, Avanti Financial Group Inc., to apply for a bank charter under Wyoming’s special-purpose depository institution law. Under the name “Avanti Bank & Trust,” the future bank is partnering with Blockstream to provide payment, custody, securities, and commodities activities for institutional customers using digital assets (“Avanti”). Though Avanti has yet to submit the bank charter application, the company has raised $1 million in seed funding and has eight products in the works that are not currently available in the U.S. market, including custody for security tokens. If successful, Avanti will be the first U.S. bank dedicated for digital assets.
Cayman Islands Mutual Funds Law (2020 Revision). Effective February 7, 2020, the Cayman Islands Government enacted an amendment to the Mutual Funds Law (2020 Revision). The 2020 Revision requires registration of previously exempt Section 4(4) Funds (generally, private funds with not more than 15 investors) with the Cayman Island Monetary Authority (“CIMA”). The 2020 Revision operates retroactively, meaning mutual funds that were previously exempted from registration under Section 4(4) will now need to comply with the registration requirements by August 7, 2020. Registration is similar to the requirements for Section 4(3) Funds, including the ‘four-eyes’ principle that necessitates funds to have at least two natural persons in management roles.
Cayman Islands Private Funds Law 2020 (“PF Law”). Effective February 7, 2020 (the “Effective Date”), the PF Law requires any Cayman Islands closed-ended fund that falls under the definition of a “private fund” to register with CIMA. Previously, “private funds” were not required to register with CIMA. A vehicle will be a “private fund” where: (1) its principal business is offering and issuing investment interests; (2) its investment interests carry an entitlement to participate in the profits or gains of the vehicle and are not redeemable or re-purchasable at the option of the investor, i.e. are closed-ended; (3) its purpose or effect is the pooling of investor funds with the aim of spreading investment risks and enabling investors to receive profits or gains from such vehicle’s investments; (4) the investors do not have day-to-day control over the investments; (5) its investments are managed as a whole by or on behalf of the operator, directly or indirectly, for reward based on the assets, profits or gains of the vehicle; and (6) it does not constitute a “non-fund arrangement,” as listed in the schedule to the PF Law. The regulations do provide certain transitional provisions for private funds that began business at any time prior to the Effective Date. Such transitional funds will have six months from the Effective Date to register with CIMA and comply with the PF Law.
European Union (EU) Announces Cayman Islands is a Non-Cooperative Jurisdiction for Tax Purposes. Effective February 18, 2020, the EU Economic and Financial Affairs Council announced that the Cayman Islands was moved to Annex 1 of Non-cooperative jurisdictions (“Annex 1”) for failing to timely implement appropriate regulations relating to economic substance in the area of collective investment vehicles. For investors or clients using Cayman structures, the move to Annex 1 will have limited or no direct practical consequence. The move to Annex 1 is not expected to trigger prevention of the use of special purpose vehicles established in non-EU jurisdictions under Article 4 of the EU Securitisation Regulation, or result in any EU level sanctions. While the Cayman Islands Government has announced the start of the delisting process, the situation is currently being monitored as dialogue continues between the EU and listed jurisdictions.
Important Second Circuit Opinion on Insider Trading. In United States v. Blaszczak, No. 18-2825 (2d Cir. Dec. 30, 2019) (“Blaszczak”), the Second Circuit denied application of any personal benefit test to insider trading charges brought under both the criminal securities fraud provisions added in the 2002 Sarbanes-Oxley Act (Title 18) and the wire fraud statutes. Although this precedent controls only in criminal cases, this Second Circuit decision has made it significantly easier for prosecutors to obtain insider trading convictions. The personal benefit test requires prosecutors to show that a tipper acquired a personal benefit by disclosing confidential information in order to charge the tipper or tippee with insider trading. The implications of the ruling are potentially far-reaching as Blaszczak may become expansive precedent for prosecutors seeking to lower the bar for insider trading prosecutions. Analysts, such as the two former hedge fund analysts to whom Blaszczak was charged, that usually communicate with company employees and executive insiders may be at higher risk for insider trading prosecution because the government may not need to allege or prove that the tipper breached a duty of confidentiality or exchange for a personal benefit. While the cascading impact following Blaszczak is yet to be known, it is clear that the Second Circuit ruling has the potential to significantly expand insider trading liability.
COVID-19 Pandemic-Related Updates
SEC Regulatory Relief for Funds and Investment Advisers Affected by COVID-19. The SEC announced it will provide conditional relief to investment advisers affected by COVID-19. The SEC order grants relief for advisers from certain Form ADV and Form PF filing obligations. Registered investment advisers (“RIAs”) and exempt reporting advisers affected by COVID-19 can expect conditional relief regarding amendments and reports on Form ADV, respectively. Further, the order provides conditional relief for RIAs affected by COVID-19 in regards to delivering amended brochures, brochure supplements or summaries of material changes to clients where the disclosures are not able to be timely delivered. Private fund advisers affected by COVID-19 can also expect relief from Form PF filing requirements. To rely upon the relief, the order requires a statement of notification to Commission staff (promptly via email to the SEC at [email protected]) of the intention to rely upon the order and the disclosure of information in the form of a brief description by the adviser of the reasons why it could not file or deliver its Form ADV or Form PF on time. Clients and investors of the adviser must also be notified. Disclosure in regards to reliance upon the order for Form PF filings should be made promptly via email to the SEC at [email protected]. The order requires filing Form ADV and/or Form PF, as applicable, as soon as practicable, but not later than 45 days from the original deadline. For general questions or concerns related to impacts of coronavirus on the operations or compliance of funds and advisers, please contact us.
California’s Attorney General Announced No Delay on Enforcement of CCPA. On March 17, a group of over 30 trade associations and businesses sent a letter to California’s Attorney General pushing to postpone the enforcement of the California Consumer Privacy Act (“CCPA”). The CCPA, which took effect on January 1, is expected to be enforced by the Attorney General starting July 1. The group who sent the letter requested a January 1, 2021 enforcement date in order to give businesses more time to prepare for enforcement given that, given the current climate of COVID-19, many are unable to prepare for enforcement and most are in need of prioritizing other business concerns, such as the well-being and health of their employees. Press reports of various statements by members of the Attorney General’s office in response to this request strongly suggest that enforcement will not be delayed. In addition, the Attorney General recently released proposed revisions to clarify the service provider exemption. One such revision would allow service providers to use personal information internally to improve their services subject to certain limitations. Nevertheless, fund managers should prepare for enforcement of the CCPA as scheduled.
Investment Management Firms May Be Considered Essential Financial Businesses Under Federal Guidance and State Orders. The Cybersecurity and Infrastructure Security Agency (“CISA”) lists asset management as a vital component of our nation’s critical infrastructure. As the federal risk advisor, CISA created guidance to help state and local governments ensure that employees essential to operations are able to continue working. In consideration of CISA’s guidance, whether or not investment management firms would be considered essential financial businesses may depend upon each State’s directives. Generally, the best practice for firms moving forward is to require workers to telework or work-from-home if possible, but allow supporting personnel to continue selective operations in the office in order to ensure the firm’s continued operation.Please read here for a state-by-state analysis of the exceptions provided in each States’ executive orders regarding essential business activities in light of the COVID-19 public emergency response.
Amidst Extreme Volatility Managers Must Assess Material Terms in Live Trading Agreements. Given extreme market volatility, managers must assess the deal terms governing trading agreements such as ISDA master agreements, prime brokerage agreements, and others as certain provisions and triggering events may detrimentally affect hedge funds in the midst of current market conditions. Provisions regarding NAV triggers, force majeure, material adverse change/effect, counterparty powers, business day determinations, business disruptions, etc. and should be reviewed in light of current market conditions. In particular, for fund managers with ISDAs in place, please read this article by Dave Rothschild, a Partner at Cole-Frieman & Mallon LLP (“CFM”).
Additional Information on COVID-19 for Investment Managers. We have summarized a number of items from various authorities that pertain to investment managers. This article details the following matters:
- The Coronavirus Aid, Relief, and Economic Security Act (CARES Act).
- CFTC Extended Deadlines for CPOs Due to COVID-19.
- SEC Update to Form ADV and Custody Rule FAQs, Relating to “Work From Home”.
- NFA Relief for Commodity Pool Operators, Relating to “Work from Home”.
- FINRA Pandemic-Related BCP, Guidance and Regulatory Relief, Relating to Regulatory Filings, “Work from Home,” Cybersecurity, and Forms U4 and BR.
- Employment Considerations for Investment Management Firms Addressing COVID-19.
- SEC Temporary Final Rule 10(c) to Address Form ID Notarization Issues.
- SEC’s Office of Compliance Inspections and Examinations Off-Site Exams via Correspondence for Information on Firms’ Business Continuity Plans.
- SEC Guidance Relating to Federal Proxy Rules for Annual Meetings, “Virtual” Meetings, and Presentations of Shareholder Proposals.
- SEC No-Action Relief for Consolidated Audit Trail Obligations.
- Short-Selling Bans in Austria, Belgium, France, Italy, and Spain.
- Tax Matters for Investment Managers.
CFM 2020 IA/BD Compliance Update with Aspect Advisors. We held our 2020 compliance update with Aspect Advisors in January. The discussion covered the critical compliance priorities in our industry for the New Year and decade. We’d like to thank Aspect Advisors for their help with this compliance update and look forward to future events. Aspect Advisors is a modern regulatory consultant providing customized compliance solutions to entrepreneurs. The firm has a focus on fintech companies, broker-dealers, and investment managers (hedge fund, VC, PE, RIA, etc.).
Bitcoin Mining Panel Event in San Francisco. As we have seen certain venture capital firms increase their investment in bitcoin mining and infrastructure, CFM decided to hold an event discussing the current investing environment, regulatory considerations, and infrastructure landscape for bitcoin mining. The discussion was presented by Michael Fitzsimmons of Williams Trading and featured a panel of bitcoin mining experts – Mathew D’Souza of Blockware Solutions, Thomas Ao of MCredit and Yida Gao of Struck Capital. For a summary of the event, please see our overview.
Regulation Best Interest (Reg BI) Webinar. Please stay tuned for more information on an upcoming live webinar, co-sponsored by CFM and Aspect Advisors, discussing practical, regulatory, and other considerations regarding Reg BI and the new Form CRS. We have previously written about Reg BI and how it pertains to private fund managers and investment advisers here. If you are interested in attending and have any questions for us to cover during the webinar, please contact us.
Compliance Calendar Please note the following important dates as you plan your regulatory compliance timeline for the coming months:
SEC deadline to update and file Form ADV – Part 1A, 2A, and Part(s) 2B, as applicable, through IARD.
Amendment to SEC Form 13H due if necessary.
|April 15||SEC deadline to file 1st Quarter 2020 Form PF filing for quarterly filers (Large Liquidity Fund Advisers), through PFRD.|
|April 15||FinCEN deadline to file Report of Foreign Bank and Financial Accounts on FinCEN Form 114. Required for U.S. person with financial interest in, or signature authority over, one or more foreign financial accounts with total value over $10,000 at any time in 2019.|
|April 29||Distribute Form ADV Part 2 to existing clients.|
|April 29||Distribute audited financial statements to private fund investors that have not invested in fund of funds.|
|April 29||SEC deadline to file Annual Form PF for annual filers (Large Private Equity Fund Advisers and Smaller Private Fund Advisers).|
|April 29||Collect quarterly Transaction Reports from access persons for their personal securities transactions.|
|May 1||SEC filing opens for Form CRS, through IARD.|
|May 15*||CFTC deadline for Commodity Pool Operators to file Schedules A and B of CFTC Form CPO-PQR, through NFA EasyFile. |
NFA deadline for CFTC-registered CPO of CFTC Regulation 4.7 Pool or Non-Exempt Pool to file 2019 Annual Report and distribute to pool participants.
|May 15||SEC deadline to file Form 13F for first quarter of 2020.|
|May 15||NFA deadline to file Quarterly Commodity Trading Advisor Form PR filing, through NFA EasyFile.|
|May. 29||SEC deadline to file 1st Quarter 2020 Form PF filing for quarterly filers (Large Hedge Fund Advisers), through PFRD.|
|May 29||CFTC deadline for Commodity Pool Operators to file Schedules A, B, and C of CFTC Form CPO-PQR, for first quarter of 2020, through NFA EasyFile.|
|May 29||CFTC deadline for Commodity Pool Operators to file NFA Form PQR for first quarter of 2020 with CFTC and NFA, through NFA EasyFile.|
|June 12*||Distribute Quarterly NAV Report (registered commodity pool operators claiming the 4.7 exemption) to pool participants.|
|June 26||Distribute audited financial statements to private fund investors that have invested in fund of funds.|
|June 30||SEC deadline to file Form CRS, through IARD if necessary.|
|Variable||Distribute copies of K-1 to fund investors.|
|Periodic FIlings||Form D and Blue Sky filings should be current.|
*Extended deadline pursuant to COVID-19 pandemic-related relief
Please contact us with any questions or for assistance with any of the above topics. Sincerely, Karl Cole-Frieman, Bart Mallon, Lilly Palmer, David Rothschild, & Scott Kitchens
Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive, and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers, as well as multi-billion-dollar firms. The firm provides a full suite of legal services to the investment management community, including hedge fund, private equity fund, venture capital fund, mutual fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog, which focuses on legal issues that impact the hedge fund community. For more information, please visit us at colefrieman.com.
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.